Thursday, 30 October 2014

This is a title that is sure to spur some angry comments.
Didn’t the financial crisis prove that mainstream macroeconomics was hopelessly
flawed, that the ‘Great Moderation’ (fifteen or so years of relatively stable
inflation and output) that preceded the crisis was a sham, or worse still a
cause of the crisis, and basing policy on lots of maths and rational
expectations has been totally discredited?

One of the architects of that macroeconomic mainstream is Lars Svensson. He wrote a number
of key papers on inflation targeting using lots of maths and rational
expectations. Probably for that reason, he was a member of Sweden’s equivalent
of the Monetary Policy Committee from 2007 to 2013. By the middle of 2009
Swedish short term interest rates were, like most other places, close to their
‘zero lower bound’ - in this case 0.25%. But in mid 2010 they began to rise
again, reaching 2% at the end of 2011. The primary motivation for this continuing rise in
rates was a concern that Swedish consumers were taking on too much debt.

Svensson fiercely and publicly opposed these increases, and
eventually left the central bank in frustration. He argued that there was still plenty of slack in
the economy, and raising rates would be deflationary, so that inflation would
fall well below the central bank’s target of 2%. By the end of 2012 inflation
had indeed fallen to zero, and since then monthly inflation has more often been
negative than positive. It was -0.4% in September. This week the Swedish
central bank lowered their interest rate to zero.

OK, so one eminent macroeconomist got a forecast right. Plenty
of others get their forecasts wrong. Why the big
deal? Suppose you took the statement in my first paragraph seriously. The Great
Moderation was about central banks having an explicit forward looking target
for inflation, and varying interest rates with the aim of trying to achieve it.
So if the success of that policy was a sham or worse, and had been exposed by
the financial crisis, a central bank should not worry too much if they abandon
it. They should certainly not worry if they deviate from it because of concerns
about the financial health of the economy. Which is exactly what the Swedish
central bank did.

Now Sweden has negative inflation, and interest rates have come
right back to zero. Deviating from what mainstream macroeconomists in general
advocate (and what one in particular recommended) has proved a costly mistake.
(Svensson estimates it has cost 60,000 jobs.) So maybe
the story with the financial crisis is a little more nuanced. Perhaps good
monetary policy, aided by the analysis of mainstream New-Keynesian theory, did help bring about the pre-crisis moderation
in inflation and output variability. The Achilles heel was that monetary policy
lost traction when nominal rates hit zero, but a number of mainstream macroeconomists had
discussed the implications of that possibility before it happened in 2009. In the UK at least (and also elsewhere), it was politicians
and central bank governors that did not take the consequences of this
possibility seriously enough. The financial crisis suggests that what was
missing was better financial regulation (including macroprudential monetary
policy tools), rather than a need to rewrite how we set interest rates.

I am certainly not claiming that mainstream macroeconomics is
without fault, as regular readers will know (e.g.) However it is important to recognise the
achievements of macroeconomics as well as its faults. If we fail to do that,
then central banks can start doing foolish things, with large costs in terms of
the welfare of its country’s citizens. And while it might appear unseemly to occasionally blow
one’s own profession’s trumpet, I suspect no one else is going to.

Wednesday, 29 October 2014

Everyone knows that the Eurozone suffered a crisis from 2010 to
2012, as periphery countries could no longer sell their debt. A superficial
analysis puts this down to profligate governments, but look more closely and it
becomes clear that the formation of the Euro itself led to an excessive
monetary stimulus in these periphery countries. This is widely understood.

But this is not the whole story. It leaves out one key element
that is vital if we are to understand the situation today. Here is a chart of
nominal wage growth (compensation per employee) in the Eurozone and selected
countries within it before the Great Recession.

Between 2000 and 2007 German wages increased by less than 10%
compared to over 20% in the Eurozone as a whole (which of course includes
Germany). This difference was not primarily caused by excessive growth in the
periphery countries: wages in France, Belgium, the Netherlands, Italy and Spain
all increased by between 20% and 30%. The outlier was Germany.

Of course growth in nominal wages of less than 2%, and
sometimes less than 1%, is not consistent with a consumer price inflation
target of close to 2%. It was for this reason that the ECB lowered short term
interest rates from 4.4% in 2000 to 2.1% in 2004. They were not worried by
excessive inflation in the periphery - they had to lower rates to counteract
the effect of low nominal wage growth in Germany. [1]

So the reason why Germany seems to have largely escaped the
second Eurozone recession of 2012/3 is that it pursued (perhaps
unintentionally) a beggar my neighbour policy within the Eurozone. Low nominal
wage growth in Germany led to lower production costs and prices, which allowed
German goods to displace goods produced in other Eurozone countries both in the
Eurozone and in third markets. This might make sense if Germany had entered the
Eurozone at an uncompetitive exchange rate, but my own analysis
suggests it did not, and Germany’s current relative cyclical position and its
current account surplus confirm this.

As I argued in an earlier post,
I do not think this divergence in cyclical position is the main reason why Germany
resists expansionary measures in the Eurozone. But it is a lot easier to take
up these obstructive positions when you are benefiting from this beggar my
neighbour policy, and other countries that have suffered as a result appear not
to understand what you have done.

[1] One of the comments on my earlier post tried to justify this beggar my neighbour policy using the following argument. Although the ECB's inflation target was close to 2%, they suggested that inflation below this was clearly desirable. What the Eurozone provided was an incentive system to try and achieve below target inflation by becoming more competitive. Germany had successfully risen to this challenge, and now it was up to other countries to try and do the same. Now if this competitiveness had been achieved by improvements in productivity, then this idea - although still mistaken - would be worth discussing. When it is achieved by cutting nominal wages (such that real wage increases are below productivity growth), it is not clear what efficiency gains are being achieved.

Postscript: Simon Tilford of the Centre for European Reform makes much the same argument here (HT Zoe Keller).

Sunday, 26 October 2014

When, almost a year ago, Paul Krugman wrote six posts within
three days laying into the stance of Germany on the Eurozone’s macroeconomic
problems, even I thought that maybe this was a bit too strong,
although there was nothing in what he wrote that I disagreed with. Yet as
Germany’s stance proved unyielding in the face of the Eurozone’s continued
woes, I found myself a couple of months ago doing much the same thing (1, 2, 3, 4, 5, 6), although at a slightly more leisurely
pace. Now it seems the whole world (apart from Germany, or course) is at it: here is a particularly clear example from Matt
O’Brien.

I’m not going to review the macroeconomics here. I’m going to
take it as read that

1)ECB monetary policy has been far too timid since the
Great Recession began, in part because of the influence of its German members.

2)This combined with austerity led to the second Eurozone
recession, and austerity continues to be a drag on demand. The leading proponent of that
austerity is Germany.

3)Pretty well everyone outside Germany agrees that a
Eurozone fiscal stimulus in the form of additional public investment, together
with Quantitative Easing (QE) in the form of government debt purchases by the
ECB, are required to help quickly end this second recession (see, for example, Guntram Wolff), and the main obstacle to both
is the German government.

The question I want to raise is why Germany appears so
successful in blocking or delaying these measures. At first the answer seems
obvious: Germany is the dominant economy in the Eurozone. However that is too
easy an explanation: while Germany’s GDP is less than a third of the Eurozone
total, the combination of French, Italian and Spanish GDP is nearly one half.
Now it could be that in the past France, Italy and Spain have failed to
coordinate sufficiently to oppose Germany, in part because France has placed a
high value on the French-German bilateral relationship. But that seems less of
a problem today.

The puzzle remains if we just view these debates as being about
national interest, rather than a battle over ideas. Germany is virtually unique
in the Eurozone in not currently having a large negative output gap, and having
low unemployment. So, you could argue, it is not in Germany’s national interest
to allow Eurozone demand to expand, and inflation to rise. But Germany achieved
this position because it undercut its Eurozone partners by keeping wages low
before 2007. If political discourse was governed by basic macroeconomics, you
would expect every other country to be very annoyed that this had happened, and
be demanding that Germany put things right by restoring a sustainable relative
competitive position through additional inflation.

These last two sentences contain a clue to resolving this
puzzle. While nearly everyone recognises the internal competitiveness problem
within the Eurozone, hardly anyone describes this as a problem caused by German
policy. Instead, as Edward Hugh suggests for example, they believe “Germany’s
unit labour costs are low not because Germans aren’t paid much, but because
they are very productive, and at the end of the day, despite all the bleating
about the current account this is the model other members of the Euro Area
(including France) not only need to but are compelled to follow: high pay and
high productivity”. I suspect many would agree with that sentiment.

Unfortunately it misses the point. International differences in
productivity occur for a variety of reasons, and they are slow to change. The
Eurozone’s current problem arises because one country - Germany - allowed nominal
wage growth well below the Eurozone average, which undercut everyone else.
(Thispostshows how real wage growth in Germany was below productivity growth in
every year between 2000 and 2007.) Within a currency union, this is a beggar my
neighbour policy.

In other words, as Simon Tilfordsuggests, Germany is viewed by many in
the Eurozone as a model to follow, rather than as a source for their current
problems. (He also plausibly suggests that Germany’s influence immediately
after 2010 reflected its creditor position, but he argues that the importance
of this factor should now be declining.) Of course in general terms Germany may
well have many features which other countries might well want to emulate, like
high levels of productivity, but the reason why it’s national interest is not
currently aligned with other union members is because its inflation rate was
too low from 2000 to 2007. That in itself was not a virtue (whatever the rights
or wrongs of why it came about), and so if they had any sense other union
members should be complaining bitterly about the German position.

I think the current Eurozone problem makes much more sense if
we focus less on divergent national interests, and more on different macroeconomic
points of view. The German perspective which sees the Eurozone problem in terms
of profligate governments and lack of ‘structural reforms’ outside Germany is
utterly inappropriate in understanding the Eurozone’s current position. Yet it
is a point of view that too many outside Germany also share.

This is beginning to change. As this Reuters report
makes clear, relations between Draghi and the Bundesbank have steadily
deteriorated, as Draghi begins to understand the macroeconomic reality. (While
I still have problems with the ECB’s current position, set out clearly in this speech by Benoît Cœuré, it makes much more
sense than anything coming from the Bundesbank or German government.) Yet, as
Simon Tilford notes, it is still not clear whether this will end in a
significant departure from current policies, or just more of the minor
adjustments we have seen so far.

It may well come down to the position taken by countries like
the Netherlands. They have suffered
as much as France in following the Eurozone’s fiscal rules to implement
damaging fiscal contraction. As Giulio Mazzolini and Ashoka Mody note, “For the Netherlands …. less austerity
would have been unambiguously better.” Yet until now, politicians
in the Netherlands (and the central
bank) appear to have taken the German line that this medicine is for their
own good. If they can eat a bit of humble pie and support a kind of ‘grand
bargain’ that would see fiscal expansion rather than contraction in the
Eurozone as a whole, and a comprehensive QE programme by the ECB, then maybe
some real progress can be made. Ultimately this is not the Eurozone’s Germany
problem, but a problem created by the macroeconomic vision that German
policymakers espouse.

Friday, 24 October 2014

I ought to start a series on common macroeconomic
misunderstandings. (I do not watch zombie films.) One would be that the central
bank’s balance sheet normally matters, although this nice comment on my last post does the job pretty
well. Here is one that crops up fairly regularly - that government debt does
not involve redistribution between generations. The misunderstanding here is
obvious once you see that generations overlap.

Take a really simple example. Suppose the amount of goods
produced each period in the economy is always 100. Now if each period was the
life of a generation, and generations did not overlap, then obviously each
generation gets 100, and there can be no redistribution between them. But in
real life generations do overlap.

So instead let each period involve two generations: the old and
young. Suppose each produced 50 goods. But in one period, call it period T, the
government decides that the young should pay 10 goods into a pension scheme,
and the old should get that pension at T, even though they contributed nothing
when young. In other words, the young pay the old. A fanciful idea? No, it is
called an unfunded pension scheme, and it is how the state pension works in the
UK. As a result of the scheme, the old at T get 60 goods, and the young only
40, of the 100 produced in period T. The old at T are clear winners. Who loses?
Not the young at T if the scheme continues, because they get 60 when old (and assume
for simplicity that people do not care when they get goods). The losers are the
generation who are old in the period the scheme stops. Say that is period T+10,
when the young get to keep their 50, but the old who only got 40 when young only
get 50 when old. So we have a clear redistribution from the old in period T+10
to the old in period T. Yet output in period T and T+10 is unchanged at 100.

That example did not involve any debt, but I started with it
because it shows so clearly how you can have redistribution between generations
even if output is unchanged. To bring in debt, suppose government taxes both
the old and young by 10 each period, and transforms this 20 into public goods.
So each generation has a lifetime consumption of 80 of private goods.

Now in period T the government says that the young need pay no
taxes, but will instead give 10 goods in exchange for a paper asset - government
debt - that can be redeemed next period for 10 goods. In period T nothing
changes, except that the young now have this asset. In period T+1 this allows
them (the now old) to consume 50 private goods rather than 40: the 40 it
produces less tax and the 10 it now gets from the government by selling the
debt. Their total consumption of private goods has increased from 80 to 90. How
does the government obtain these 10 to give the now old? It says to the young:
either you pay 20 rather than 10 in taxes, or you can buy this government debt
for 10. As people only care about their total consumption, the young obviously
buy the debt. They now consume 30 in private goods in T+1, but 50 in T+2 when
they sell their debt, which gets us back to the original 80 in total lifetime
consumption.

This process continues until period T+10, say, when the
government refuses to give the young the choice of buying debt, and just raises
an extra 10 in taxes on the young. So the debt disappears, but the young are
worse off, as they only have 30 of private goods to consume this period. Their
total lifetime consumption of private goods is 70. We have a clear
redistribution of 10 from the young in period T+10 to the young in period T
enacted by the government issuing debt in period T.

If you are thinking that these redistributions need not occur
if the debt is never repaid or the pension scheme never wound up, then we need
to get a bit more realistic and bring in interest rates and growth (and the
famous r<>g relationship), which these posts of mine (and these at least
as good posts from Nick Rowe) discuss. But the idea with this post is to get
across in a very simple way how redistribution between generations can work
because generations overlap.

Wednesday, 22 October 2014

Periodically articles appear advocating, or discussing,
helicopter money. Here is a simple guide to this strange sounding concept. I go
in descending order of importance, covering the essential ground in points 1-7,
and dealing with more esoteric matters after that.

Helicopter
money is a form of fiscal stimulus. The original Friedman thought
experiment involved the central bank distributing money by helicopter, but
the real world counterpart to that is a tax cut of some form.

What
makes helicopter money different from a conventional tax cut is that
helicopter money is paid for by the central bank printing money, rather
than the government issuing debt.

The
central bank printing money is nothing new: Quantitative Easing (QE)
involves the central bank creating reserves and using them to buy
financial assets - mainly government debt. As a result, helicopter money
is actually the combination of two very familiar policies: QE coupled with
a tax cut. Another way of thinking about it: instead of using money to buy
assets (QE alone), the central bank gives it away to people. If you think
intuitively that this would be a better use of the money as a means of
stimulating the economy, I think you are right.

Is
it exactly the same as a conventional tax cut plus QE? A conventional tax
cut would involve the government creating more debt, which the central
bank would then buy under QE. With helicopter money no additional
government debt would be created. But is government debt held by the
central bank, where the central bank pays back to the Treasury the
interest it receives on this debt, really government debt in anything more
than name only? The answer would appear to be yes, because the central
bank could decide to sell the debt, in which case it would revert back to
being normal government debt.

However
at this point we have to ask what the aim of the central bank is. Suppose
the central bank has an inflation target. It achieves that target by
changing interest rates, which it can either control (at the short end) or
influence (at the long end) by buying or selling assets of various kinds.
So central bank decisions about buying and selling government debt are
determined by the need to hit the inflation target. Given this, whether
money is created by buying government debt (through QE) which finances the
tax cut or by financing the tax cut directly seems immaterial, because
decisions about how much money gets created in the long run are determined
by the need to hit the inflation target.

There
is a general principle here that should always be born in mind when
thinking about helicopter money. The central bank cannot independently
control inflation and control money creation - the two are linked in the
long run (although the short run may be much more unpredictable). Now it could be that advocates of helicopter money
really want higher inflation targets, but do not want to be explicit about
this, just as they may
not want to call helicopter money a fiscal stimulus. The problem with this
is that central bankers do understand the macroeconomics, so there seems little point
trying to be deceptive. If helicopter money does not mean higher inflation
targets, then this policy is just fiscal stimulus plus QE. (I elaborate on
this point here,
and discuss but largely discount possible differences here.
A less technical discussion is here.)

Saying
that helicopter money is 'just' fiscal stimulus plus QE is not meant to be
dismissive. Mark Blyth and Eric Lonergan make
the quite legitimate point that our institutional separation between
monetary and fiscal policy may not be appropriate to a world where the
liquidity trap may be a frequent problem. Many years ago I suggested in a FT piece
that the central bank might be given a limited ability to temporarily
change a small number of fiscal instruments to enhance its control over
the economy. The more recent proposal
outlined by Jonathan Portes and myself has some similarities with this
idea.

Turning
to the tax cut, would this work in stimulating consumption? A familiar
objection to a bond financed tax cut is Ricardian Equivalence: people just
save the tax cut because they know taxes will increase in the future to
pay the interest on the new debt. Now we know that for very good reasons
Ricardian Equivalence does not hold in the real world, so we are entering
the territory of angels and pins here, and as a result you may want to stop reading
now. If not, the question is: if Ricardian Equivalence did hold, would a
tax cut financed by printing money be subject to the same problem? Here we
come to the issue of whether central bank money is 'irredeemable'. The next point explains.

Ricardian
Equivalence works because, to avoid having to reduce future consumption
when taxes rise to pay the interest on the government debt created by the
original tax cut, consumers are forced to invest all of the tax cut. If a
£100 tax cut implies taxes are higher by £5 each subsequent year to pay a
5% interest rate, then if the rate of interest consumers can receive is
also 5%, to generate an extra £5 each year to pay those higher taxes they
have to invest all £100 of the tax cut. Now suppose the tax cut is
financed by printing money. There is now no interest to pay. So if
the central bank never wanted to undo its money creation, there is no
reason why private agents who hold this money should not regard it as
wealth and at some point spend it. This is what is meant by money being
irredeemable.

However
we need to recall that the central bank may have an inflation target. For
that reason, it may want to undo its money creation. If people expect that
to happen, they will not regard their money holding as wealth. The logic
of Ricardian Equivalence does apply. (The central bank may not be able to
reduce money by raising taxes, but it can sell its government debt
instead. Now the government has to pay interest on its debt, so taxes will
rise.) This is why Willem Buiter stresses
that it is expected future money, not current money, that is regarded as
wealth.

Tony
Yates has a recent post on
this. He argues that if the central bank assumes money is irredeemable,
and starts printing a lot of it, people may stop wanting to use it. If
they do that, it will no longer be seen as wealth. This is real angels and
pins stuff that can come from taking microfoundations too seriously. Just
ask yourself what you would do if you received a cheque in the post from
the central bank. As Nick Rowe points out in this post,
we can cut through all this by noting the link between money creation and
inflation targets. The money required to sustain an inflation target will
not be redeemed, so it can be regarded as wealth.

Suppose
central banks do stick to their inflation targets, but are having trouble
achieving them because inflation is too low and we are in a liquidity
trap. Without helicopter money, the inflation target will be
undershot. That is the context
of the current discussion. Might agents save the tax cut, because they
will anticipate higher prices and recognise that they will need the
additional money as a medium of exchange? As I discuss here,
this is not a problem because the increase in prices will reduce real
interest rates, which will stimulate the economy that way. As Willem
Buiter says, "there always exists a combined monetary and fiscal
policy action that boosts private demand".

Tuesday, 21 October 2014

In a previous post I speculated on how the disaffected voter could be both part of the UKIP story and also a factor behind the decline
in the popularity of the LibDems. But what about UKIP’s two key policy areas:
leaving Europe and stopping immigration?

As I noted last time, for most UKIP voters Europe itself is no
big deal. It is an issue which will sit naturally with disaffected
voters: if UK politicians seem remote to their interests, politicians in Europe
will seem even more so. It is not an issue that a large number of voters will regard as all important in itself. Immigration is much more interesting. This post looks
at what evidence we can get from surveys about voter attitudes towards immigration.

The first point to make is that a large majority of the UK
public have always favoured tighter controls on immigration. (Interestingly,
given SNP policies for an independent Scotland, a majority of Scottish voters also want less immigration!) What has changed
over the last two decades has been the salience of the issue. (The charts in
this post come from the three sources listed at the end.)

This chart is a little busy, but the green line is the number
of people rating race and immigration as one of the top issues. The issue was
nowhere until the end of the 1990s. Within the space of about four years its
importance rose dramatically, and it has stayed as a key issue since around
2003.

The temporal link with actual levels of migration cannot be a complete
coincidence.

Note that immigration from the EU only took off from 2004. So
freedom of movement for labour within the EU, which is discussed so much in the
media, is not the key to understanding voter concern about immigration.

Nor does concern about immigration appear to involve class. Any differences between the standard social classifications
(A-E) and voter concern seems to be swamped by a common movement, as this chart
shows.

There is, however, an understandable difference between income
groups when they are asked why they are concerned about immigration. Those with
low incomes tend to want to reduce immigration because of the perceived impact
on jobs and housing, while those on higher incomes are more concerned about the
impact on public services.

There are also two additional class related factors which do
distinguish between voters attitudes towards the impact of immigration. The
first is whether the voter has a university degree. For those that do, the majority
believe that immigration has benefited the country both economically and
culturally, while those without a degree think the opposite. Second, there is a
clear correlation between concern about immigration and the newspaper people
read. In addition, people seriously overestimate the extent of UK immigration,
probably because of the impression they get from reading certain newspapers. To some extent this may be inevitable, as sensationalism like this or this may help sell newspapers to those who worry about immigration. However the fact that large sections of the UK press want us to leave the EU may mean that causality runs the other way, as I note below. (I do not see this as a simple right-left issue, as many on the right are against tight
immigration controls.)

Location is also important. One widely reported result is that
concern about immigration tends to be higher where actual levels of immigration
are low. (An exception seems to be where asylum seekers are placed.) Many have noted that UKIP’s first MP is in a
constituency where levels of immigration are very low. Chris Dillow mentions one poll that found that while 76%
think immigration is a very or fairly big problem for Britain, only 18% think
it is in their own area. Furthermore those with migrant friends were far more
likely to be positive about the impact of immigration than those without.

So immigration for many is about a fear rather than perceived experience. The fear is fed not by official statistics but stories in the media. In that sense it is like crime. In the case of crime, the general perception is that crime is rising, even though for many years nearly every type of crime has been falling in the UK. This encourages politicians to focus on the appearance of action: most calculate that they are better off talking about 'cracking down' on crime than in celebrating its decline. With immigration, the political benefits of appearing to 'deal with the problem of immigration' are greater than arguing that, in average economic terms at least, immigration may not be a problem at all. Two things make immigration particularly toxic as a political issue. The first is that economic issues (jobs, housing, public services) can so easily be linked to it. However the first chart should warn against a belief that immigration concerns will disappear if real wages begin to rise. The second is the link with EU membership. While it is clear that public concerns about immigration became important long before immigration from the EU rose substantially, it suits those that want us to leave the EU to suggest that EU immigration is critical to public perceptions on this issue. For that reason, it seems unlikely that the political 'problem of immigration' is going to go away as long as the UK remains in the EU. If this last statement is true, there is an interesting implication. UKIP can continue to receive strong support by saying that they have the only certain way of 'tackling immigration', and this will be true whatever actually happens to the numbers (immigration is like crime). The question that then arises is whether the Conservative party can live with that. Promising a referendum and then staying in the EU may win the next election but it will not make UKIP go away. Instead the party may calculate that the only way of making the issue of immigration less toxic is to take the UK out of the EU.

Tuesday, 14 October 2014

Suppose you had just an hour to teach the basics of
macroeconomics, what relationship would you be sure to include? My answer would
be the Phillips curve. With the Phillips curve you can go a long way to
understanding what monetary policy is all about.

My faith in the Phillips curve comes from simple but highly
plausible ideas. In a boom, demand is strong relative to the economy’s capacity
to produce, so prices and wages tend to rise faster than in an economic
downturn. However workers do not normally suffer from money illusion: in a boom
they want higher real wages to go
with increasing labour supply. Equally firms are interested in profit margins,
so if costs rise, so will prices. As firms do not change prices every day, they
will think about future as well as current costs. That means that inflation
depends on expected inflation as well as some indicator of excess demand, like
unemployment.

Microfoundations confirm this logic, but add a crucial point
that is not immediately obvious. Inflation today will depend on expectations
about inflation in the future, not expectations about current inflation. That
is the major contribution of New Keynesian theory to macroeconomics.

This combination of simple and formal theory would be of little
interest if it was inconsistent with the data. A few do periodically claim just
this: that it is very hard to find a Phillips curve in the data. (For example here is Stephen Williamson talking about
Europe - but see also this from László Andor claiming just the
opposite - and this from Chris Dillow on the UK.) If this was
true, it would mean that monetary policymakers the world over were using the
wrong framework in taking their decisions.

So is it true? The problem is that we do not have good data
series going back very far on inflation expectations. Results from estimating
econometric equations can therefore vary a lot depending how this crucial
variable is treated. What I want to do here is just look at the raw data on
inflation and unemployment for the US, and see whether it is really true that
it is hard to find a Phillips curve.

The first chart plots consumer price inflation (y axis) against
unemployment (x axis), where a line joins one year to the next. We start down
the bottom right in 1961, when inflation was about 1% and unemployment 6.7%.
Over the next few years we get the kind of pattern Phillips originally
observed: unemployment falls and inflation rises.

The problem is that with inflation rising to 5.5% in 1969, it
made sense for agents to raise their expectations about inflation. (In fact
they almost surely started doing this before 1969, which may give the line from
1961 to 1969 its curvature. For given expectations, the line might be quite
flat, a point I will come back to later.) So when unemployment started rising
again, inflation didn’t go back to 1%, because expected inflation had risen.
The pattern we get are called Phillips curve loops: falling unemployment over
time is clearly associated with rising inflation, but this short run pattern is
overlaid on a trend rise in inflation because inflation expectations are rising.
Of course the other thing going on here is that we had two oil price hikes in
1974 and 1979. The chart finishes in 1980.

Most economists agree that things changed in 1980, as Volker
used monetary policy aggressively to get inflation down. The next chart plots
inflation and unemployment from 1980 to 2000.

Inflation came down from 13.5% in 1980 to 3.2% in 1983 partly
because unemployment was high, but also because inflation expectations fell
rapidly. (We do have survey evidence showing this happening.) The remaining
period is dominated by a large fall in unemployment. So why didn’t this fall in
unemployment push inflation back up? In terms of the chart, why isn’t the 2000
point much higher? Again expectations are confusing things. One survey has inflation
expectations at around 5% in 1983, falling towards 3% at the end of 1999. So
inflation was being held back for that reason. A Phillips curve, and its loops,
is still there, but pretty flat.

The final chart goes from 2000 to 2013. Note that the inflation
axis has changed - it now peaks at 4.5% rather than 16%. The interesting point,
which Paul Krugman and others have noted, is that this looks much more like
Phillips’s original observation: a simple negative relationship between
inflation and unemployment. This could happen if expectations had become much more anchored as a result of credible
inflation targeting, and
survey data on expectations do suggest this has happened to some extent. There
are also important changes in commodity prices happening here too.

While the change in inflation scale allows us to see this more
clearly, it hides an important point. Once again the Phillips curve is pretty
flat. We go from 4% to 10% unemployment, but inflation changes by at most 4%.
However from the previous discussion we can see that this is not necessarily a
new phenomenon, once we allow for changing inflation expectations.

Is it this data which makes me believe in the Phillips curve?
To be honest, no. Instead it is the basic theory that I discussed at the
beginning of this post. It may also be because I’m old enough to remember the
1970s when there were still economists around who denied that lower
unemployment would lead to higher inflation, or who thought that the influence
of expectations on inflation was weak, or who thought any relationship could be
negated by direct controls on wages and prices, with disastrous results. But
given how ‘noisy’ macro data normally is, I find the data I have shown here
pretty consistent with my beliefs.

Sunday, 12 October 2014

After Thursday’s UK by-elections,
we have had a huge amount of ‘Oh God, what will it all mean, will politics ever
be the same again’ speculation. As Labour nearly lost one of its safe seats,
they as well as the Conservatives are trying hard not to panic. Some writers
have optimistically coupled this result with the Scottish referendum turnout to
suggest there is a new engagement in politics (but not of the conventional
kind) and a search for ‘political identity’. Others have more pessimistically
drawn parallels with the rise of fascism. (Are these two contradictory?)

If you see everything in terms of a left-right spectrum, then
UKIP’s popularity seems to indicate a dramatic shift to the right. Here is the
share of the popular vote gained in elections since 1945, but ending with an
average of current polls.

If we place the LibDems as somewhere near the centre of this
spectrum, then we have a fairly even balance between parties of the right and
left - until now. So has there been a sharp movement to the right among the
electorate? UKIP policies are clearly to the right of the Conservatives. But it
may be a mistake to confuse the party and its policies with the views of those
currently voting for them. Here is Owen Jones noting how UKIP voters tend
to want to renationalise the railways and energy companies, increase the
minimum wage substantially, and keep the NHS within the public sector.

Perhaps we should see UKIP as an anti-Europe party, something
outside the left-right spectrum? Again the party is not the same as its
supporters. Only a quarter of UKIP voters in this survey said resolving Britain’s future
relations with the European Union is one of the three most important issues currently facing the country.
Conservative MPs may be switching to UKIP because of Europe, but it is not
clear that UKIP voters are.

Before leaving this chart, we should note that the rise in UKIP
is not the only recent dramatic change. The other is the decline of the LibDem
vote. In the by-election where Labour only just retained their seat, we
actually saw Labour keep its 2010 share of the vote. The gain in UKIP’s share
was accounted for by a roughly equal decline in the share of the Conservatives
and LibDems. As many Conservatives will have been voting tactically, we once
again see an apparent shift from LibDem to UKIP.

Now we know that around half of UKIP voters used to
vote Conservative, not LibDem. We also know that a significant number of
ex-LibDem voters (about a third?) have moved to Labour, as we
might have expected as a result of forming a coalition with the Conservatives.
But about 20% of UKIP voters who voted for another party in 2010 are ex-LibDem
voters - that is about half a million voters. (The equivalent
number for Labour is 15%) Anyone familiar with LibDem policies would be
surprised the figure is this high: UKIP wants to leave Europe, but the LibDems
have always been the most pro-Europe party. However this may be making the same
mistake again: assuming that voters’ views map to party policies.

Here is an alternative idea that might be part (and only part)
of the story. (It is far from original - see Adam Lent for example.) An important underlying trend
since perhaps the 1960s is the rise of the disaffected voter. These are voters
with no strong ideological affiliations, and with little interest or knowledge
of politics. What they do feel strongly about, however, is that politicians in
power do not represent their views or interests, and that ‘they are all as bad
as each other’. What will attract these voters are politicians who are not part
of the ‘Westminster elite’, because they are untainted by government. This is
not a peculiar UK phenomenon - not being part ‘of Washington’ is a constant
appeal in the US. This, rather than policies, may be the key factor for these
voters.

The emergence of this group could explain some part of the rise
in the LibDem vote since the 1970s. By joining the coalition after the 2010
election the LibDems not only lost their more left leaning supporters, they also
lost the support of the disaffected voter, because they were now part of
government. Very quickly their image changed from plucky outsiders to part of
the Westminster establishment, and they could no longer be the party of the
disaffected voter. But neither could Labour, who not only had been recently in
government, but continued to behave as they did in government. The disaffected
voter needed somewhere to go, and for some UKIP became their home.

Of course a large part of UKIP’s support is from disgruntled
Conservatives. But if that was the complete story, UKIP’s rise would only be a
problem for the Conservatives, and Labour would be quietly encouraging UKIP.
This is clearly not the case. If this idea of the disaffected voter sounds
similar to the old idea of the protest vote, that is partly true, but with an
important difference. Protest votes are generally assumed to melt away come
general elections, but this will not be true of the disaffected voter. For that
reason, expecting UKIP to fade away may be naive.

By now you are probably screaming: what about immigration! I
think immigration is the kind of the issue that the disaffected voter would
focus on. But this post is already too long so my thoughts will have to wait,
although I think Chris Dillow is on the right track.

Friday, 10 October 2014

The debate about the current state of academic macroeconomics
continues, but it has reached a kind of equilibrium. Heterodox economists, some
microeconomists and many others are actively hostile to the currently dominant
macro methodology. Regardless, academic macroeconomists in the papers they
write carry on using, almost exclusively, microfounded DSGE models. [1] Critics
say this methodology was crucial in missing the financial crisis, but academic
macroeconomists respond by highlighting all the work currently being done on
financial frictions. I personally think missing the crisis was down
to failings of a different kind, but that DSGE did hold back our ability to understand the
impact of the crisis. However what I want to suggest here is a forward looking
test.

Many of the difficult choices in conducting monetary (and
sometimes fiscal) policy involve trade-offs between inflation and unemployment.
We saw this in the UK particularly after the crisis, with inflation going well
above target during the depth of the recession. What you do in those
circumstances depends critically on the costs of excess inflation compared to
the costs of higher unemployment. Is 1% higher unemployment worth more or less
than 1% higher inflation to society as a whole?

What do New Keynesian DSGE models say about this trade-off?
They do not normally model unemployment, but they do model the output gap,
which we can relate to unemployment. Their answer is that inflation is much the
more important variable, by a factor of ten or more. One reason they do this is
that they implicitly assume the unemployed enjoy all the extra leisure time at
their disposal. I have discussed other reasons here.

Empirical evidence, and frankly common sense, suggests this is
the wrong answer. Thanks to the emergence of a literature that looks at
empirical measures of wellbeing, we now have clear evidence that unemployment
matters more than inflation. Sometimes, as in this study by Blanchflower et al, it matters much
more. Another recent study by economists at the CEP shows that “life
satisfaction of individuals is between two and eight times more sensitive to
periods when the economy is shrinking than at times of growth”, which as well
as being related to the unemployment/inflation trade-off raises additional
issues around asymmetry.

So the DSGE models appear to be dead wrong. Furthermore the
reasons why they are wrong are not deeply mysterious, and certainly not
mysterious enough to make us question the evidence. For example prolonged
spells of unemployment have well documented scarring effects (in part because
employers cannot tell if unemployment was the result of bad luck or bad
performance), which may even affect the children of the unemployed. So it is
not as if economists cannot understand the empirical evidence.

Does that mean that the DSGE models are deeply flawed? No, it
means they are much too simple. Does that mean that the work behind them
(deriving social welfare functions from individual utility) is a waste of time?
I would again say no. I have done a little work of this kind, and I understood
some things much better by doing so. Will these models ever get close to the
data? I do not know, but I think we will learn more interesting and useful
things in the attempt. The microfoundations methodology is, in my view, a progressive
research strategy.

So academics are right to carry on working with these models.
But many academic macroeconomists go further than this. They argue that only microfounded DSGE models can
provide a sound basis for policy advice. If you press them they will say that
maybe it is OK for policymakers to use more ‘ad hoc’ models, but there is no
place for these in the academic journals. In my view this is absolutely wrong
for at least two reasons.

First, models that are clearly still at the early development
stage should not be used to guide policy when we can clearly do better. In this
particular case we can easily do better just by using ad hoc social welfare
functions on top of an existing DSGE model. (The Lucas critique does not apply, which is why I like this
example.) Yes these hybrid models will be ‘internally inconsistent’, but they
are clearly better! Second, to confine academics to just doing development work
on prototype experimental models is stupid: academic economists can have many
useful things to say starting with aggregate models (as here, for example),
and this is not something that policymakers alone have the resources (or
sometimes the inclination) to do. (We also know that academics will give policy
advice, whatever models they use!) Analysis using these more ad hoc but realistic
models should be scrutinised in high quality academic journals.

Let’s be even more concrete. Take the debate over whether we
should have a higher (than 2%) inflation target (or some other kind of target),
because of the risks of hitting the zero lower bound. If this debate just
involves micofounded DSGE models which clearly overweight inflation relative to
unemployment, then these models will be guilty of distorting policy. This is
not a matter of running some variants away from microfounded parameters (as in this comprehensive analysis, for example), but
adopting realistic parameters as the base
case. If this is not done, then microfounded DSGE models will be guilty of distorting this policy discussion.

[1] A few elderly bloggers, who use both DSGE and more ‘ad hoc’
models and think the critics have a point, are regarded by at least some academics as simply past their sell-by
date.

Thursday, 9 October 2014

The macroeconomic case for not cutting the deficit straight after a major recession is as watertight as these things get, at least outside of the Eurozone. (It is also true for the Eurozone, but just a bit more complicated, so its easier to just focus on the US and UK in this post.) If you want to bring the government deficit and debt down, you do so when interest rates are free to counter the impact on aggregate demand. As the problems of high government debt are long term there is no urgency for debt reduction, so the problem can wait. The costs of fiscal consolidation in a liquidity trap are large and immediate, as we have experienced to our cost.

Sometimes austerity proponents will admit this basic macroeconomic truth, but say that it ignores the politics. Politics means that it is very difficult for governments to reduce debt during booms, they say. Although it would be nice to wait for interest rates to rise before cutting the deficit, it will not happen if we do, so we have to cut now. Like all good myths, this is based on a half truth: in the 30 years before the recession, debt tended to rise as a share of GDP in most OECD countries. And it always sounds wise to say you cannot trust politicians.

However both the UK and US show that this is not some kind of iron law of politics. In the UK debt came down from over 100% of GDP between the wars to less than 50% of GDP by the mid-1970s, and was lower still before the recession. (Debt was lower before the recession than when Labour came to power in 1997.) US debt also fell sharply after WWII, but rose again under Reagan and Bush, fell under Clinton and then rose again under the other Bush. So the empirical evidence on US and UK debt is not that it is inherently difficult to reduce in booms; it is do not elect Republican presidents.

My reason for returning to this issue was thinking about the post 2015 UK election plans of all three main political parties. As I have outlined before, all involve tight fiscal control - in my opinion tighter than would be prudent from a macroeconomic point of view. This is fully six years after the recession. So it looks like politics is capable of promising fiscal consolidation well after a crisis. Are we meant to believe that if instead of austerity we had had additional fiscal stimulus after the recession, within the framework that Jonathan Portes and I suggest, things would have been quite different by 2015?

[1] It is true that no party is - as yet - telling us exactly how these numbers would be achieved, but this does not mean it will not happen: the Conservatives delivered in 2010, and Labour broadly stuck to its fiscal rules until the recession. The only party to go back on their election promises were the LibDems, who campaigned for less austerity than they ended up delivering.

Wednesday, 8 October 2014

Price stability is the primary objective of the ECB, as laid down in the Treaty on the Functioning of
the European Union, Article 127 (1). The ECB gets to choose how to interpret
price stability, and it does this as “inflation rates below, but close to, 2%
over the medium term.” Why ‘below but close to’? If this means 1.8% or 1.9%, it
would seem very odd. How do the ECB know that 1.8% inflation is the right
target?

I suspect the answer is that this formulation is a compromise,
between those who wanted a commitment to inflation below 2% (which could mean
zero) and those that wanted just 2%. Is this constructive ambiguity? I cannot
see how it can be. The whole point about inflation targeting is to provide a
clear signal about the objectives of the monetary authority.

Now this would not matter much if everyone involved in ECB
monetary policy was of one mind. However they clearly are not. Here is Jürgen Stark, who was sometimes
referred to as chief economist of the ECB until he left at the end of 2011,
talking about the current conjuncture:

“The current inflation
rate of 0.3% is due to the significant decline in commodity prices
and the painful but unavoidable adjustment of costs and prices in the
peripheral countries. Only Greece currently has a slightly negative inflation
rate. In other words, price stability reigns in the eurozone. This strengthens
purchasing power and ultimately private consumption. The ECB has fulfilled its
mandate for the present and the foreseeable future. There is no need for policy
action in the short term.”

Are these views of the past? Or do some who continue to sit on
the Governing Council still have sympathy for these views? Is this about
principle, or national interest: ECB rates were cut substantially when the German economy
was weak in 2002-5, rather than let inflation fall below 2%. Speculation of
this kind is fine for those who make money from it, but inflation targets
should be clear and unambiguous. Allowing people to believe that maybe the ECB
is not too bothered about below 2% inflation could be very dangerous because of the zero lower bound.

The solution to this problem seems terribly straightforward.
All the academic discussion is about whether inflation targets should be higher
than 2%, not lower, because the chances of hitting the zero lower bound are
clearly greater than had been thought. With Stark and others no longer there, perhaps the ECB can agree (by majority vote if necessary) to target just
2%, and those that cannot abide by that decision can leave - as Stark officially did - for 'personal reasons'. If the ECB cannot do this by themselves, then Eurozone governments should tell them to do this. I have never
understood why the inflation target itself should be something that is decided
behind the closed doors of central banks.

One final thought on the Stark article. He too uses the phrase “Anglo-Saxon economists”.
I am at a loss to know what this is meant to signify. For a few who comment on
my posts it means that we are part of a plot to ensure the Eurozone fails, but
is this what Stark means? Perhaps there is some reason why the theories of
economics developed in the UK and US do not apply in the Eurozone. However the
work I have seen done by ECB economists would not look out of place if done at
the Fed or IMF, and from his experience Stark must know this. Some people refer
to ordoliberalism. But if ordoliberalism differs from Anglo-Saxon neoliberalism
in theory rather than practice, it seems to me this is because it takes more
rather than less notice of mainstream economics. If it means disagreeing with
almost everything in the paragraph of his quoted above, then I think many
non-Anglo-Saxon economists would be in that group. Perhaps, like the phrase ‘below but close to 2%’, we will never know quite what it means.

Tuesday, 7 October 2014

A constant refrain, from both the Conservative and LibDem
party conferences, is how the current government saved the country from a
crisis. Here
is Osborne: “Four years ago, our economy was in crisis, our country was on the
floor.” Or LibDem Danny Alexander: “We’ve seen the economy through its darkest
hour ..” Now someone from outside the UK would immediately think Osborne and
Alexander had got their counting wrong: the Great Recession was in 2009, which
was five not four years ago. But of course they do not mean that little old crisis - they
are talking about the Great Government Debt crisis. The only problem is that
this debt crisis is as mythical as the unicorn.

The real crisis was the Great Recession. And if any politicians can claim to have saved the country from that crisis, it is Labour's Gordon Brown and Alistair Darling. They introduced stimulus measures
(opposed by Conservatives) that helped arrest the decline in GDP. By 2010,
which is when Osborne took over, the economy was growing by nearly 2%.

But surely there was a debt crisis in 2010? Indeed there
was, in other countries. Crucially, these were countries that could not print
their own currencies. This became apparent when interest rates on Greek debt
went through the roof. Interest rates on UK and US government debt after the
recession stayed well below levels observed before the recession. UK and US
governments never had any problems raising money, for the simple reason that there was never any chance they would default.

So wrong time, wrong country, but also maybe wrong people.
Consumers and firms in the US and UK did feel they had borrowed too much, or
wanted to save more, as a result of the financial crisis. The personal savings
ratio in both countries rose substantially, and stayed high for a number of
years. But people need something to save, like government debt. Which is one
reason why interest rates on UK and US government debt stayed low: although the
supply of that debt increased, the demand for it was increasing even faster.

So why do we not hear Labour claiming that they saved us
from a crisis - at least their crisis was real! Why do claims that the current
government saved us from an entirely mythical crisis generally go unchallenged? Such claims are the equivalent to the Republican Congress claiming they saved the US economy. Welcome to the strange world of mediamacro. What the media should be doing, the
next time this government claims it saved us from the Great Government Debt crisis, is to borrow a phrase from Jim
Royle: crisis my arse!

Monday, 6 October 2014

In the textbooks it is suggested that Keynesian economics is
what happens when ‘prices are sticky’. Sticky prices sound like prices failing
to equate supply and demand, which in turn sounds like markets not working.
Hence whether you believe in Keynesian theory depends on whether you think
markets work, so it obviously maps to a left/right political perspective.

Reality is rather different. Suppose we start from a position
where firms are selling all they wish. Aggregate demand equals aggregate
supply. If then aggregate demand for goods falls, perhaps because consumers or
firms are trying to rebuild their balance sheets after a financial crisis,
producers of these goods will start to reduce output, and lay off workers. The
idea that they would ignore the fall in demand and just carry on producing the
same amount is ludicrous. So output appears to be influenced by aggregate
demand at least in the short run, which is at the heart of what most economists
think of as Keynesian theory.

So where do sticky prices come in? Here we have to go back to
the textbooks, and to an imaginary world where the monetary authority fixes the
money supply. Firms, in an effort to stimulate demand for their goods, cut
prices. Lower prices mean people do not need to hold so much money to buy goods.
However if the nominal money supply is fixed, interest rates will fall to
encourage people to hold more money. The textbooks encourage us to think of a
market for money, with interest rates as the price that equates supply and
demand. Lower interest rates provide an incentive to consumers and firms to
increase demand, which in turn raises output.

Now suppose that firms carry on cutting prices as long as they
are selling less than they would like. The process just described will
continue, with interest rates getting lower and aggregate demand rising in
response. The process stops when firms stop cutting prices, which means aggregate
demand has increased back to its original level. Suppose further that prices
adjusted very quickly. This mechanism would work very quickly, so we would only
observe aggregate demand being below supply for very short periods. If prices
were extremely flexible, we could ignore aggregate demand altogether in
thinking about output. Hence aggregate demand matters only if ‘prices are
sticky’.

Note that this correction mechanism is quite complex, and some
way from the simple microeconomic world of the market for a single good. But we
need to move back to the real world again. Monetary authorities do not fix the
money supply; they fix short term interest rates. So they are directly in charge of the correction mechanism that is at
the heart of this story. If central banks had some way of knowing what
aggregate supply was, and also had perfect knowledge of aggregate demand and
how interest rates influenced it, they could make sure aggregate demand
equalled supply without any need for prices to change at all. Equally, if
prices were very flexible but the monetary authority always moved nominal rates
in such a way as to fail to stimulate aggregate demand, aggregate demand and
therefore output would not return back to equal aggregate supply. Demand would
still matter, even with flexible prices.

Once you see things as they are in the real world, rather than
as they are portrayed in the textbooks, the importance of aggregate demand (and
therefore of Keynesian theory) is all about how good monetary policy is, and not
about sticky prices. If monetary policy was perfect, then
Keynesian theory would only be used by central banks in order to be perfect,
and everyone else could ignore it. Of course for many good reasons monetary
policy is not perfect, and so Keynesian theory matters.

We could re-establish the link between Keynesian theory and
price flexibility by assuming the monetary authority follows a rule which would
make policy perfect if and only if prices moved very fast, but the key point
remains. The importance or otherwise of Keynesian theory depends on monetary
policy. It is not about market failure. Keynesian economics is not left wing,
but it is about how the economy actually works, which is why all monetary
policymakers use it.

It is also common sense, which is why I’m often perplexed by
those who dispute Keynesian ideas. Now maybe they are confused by the strange world
portrayed in textbooks, but even if they think it is all about ‘sticky prices’,
the evidence that prices are slow to adjust is overwhelming, so it is hard to
dispute Keynesian theory on those grounds. Yet a whole revolution
in macroeconomic theory was based around a movement that wanted to overthrow
Keynesian ideas, and build models where this correction mechanism I described
happened automatically. The people who built these models did not describe them
as assuming monetary policy worked perfectly: instead they said it was all
about assuming markets worked. As a description this was at best opaque and at
worst a deliberate deception.

So why is there this desire to deny the importance of Keynesian
theory coming from the political right? Perhaps it is precisely because
monetary policy is necessary to ensure aggregate demand is neither excessive nor
deficient. Monetary policy is state intervention: by setting a market price, an
arm of the state ensures the macroeconomy works. When this particular procedure
fails to work, in a liquidity trap for example, state intervention of another
kind is required (fiscal policy). While these statements are self-evident to
many mainstream economists, to someone of a neoliberal or ordoliberal
persuasion they are discomforting. At the macroeconomic level, things only work
well because of state intervention. This was so discomforting that New
Classical economists attempted to create an alternative theory of business
cycles where booms and recessions were nothing to be concerned about, but just
the optimal response of agents to exogenous shocks.

So my argument is that Keynesian theory is not left wing,
because it is not about market failure - it is just about how the macroeconomy
works. On the other hand anti-Keynesian views are often politically motivated,
because the pivotal role the state plays in managing the macroeconomy does not
fit the ideology. Is this asymmetry odd? I do not think so - just think about
the debate over climate change. Now of course it is true that there are a small
minority of scientists who do not believe in manmade climate change and who are
not politically motivated to do so, and I’m sure the same is true for Keynesian
theory. But to claim that the majority of anti-Keynesian views were innocent of
ideological preference would be like – well like trying to pretend that
monetary policy has no role in stabilising the business cycle.

There are of course many differences between climate change
denial and anti-Keynesian positions. One is the extent to which the antagonism
has infiltrated the subject itself. Another is the extent to which the
mainstream wants to deny this influence. I do wonder if the unreal view of
monetary policy that remains in the textbooks does so in part so as to not
offend a particular ideological position. I do know that macroeconomics is
often taught as if this ideological influence was non-existent, or at least not
important to the development of the discipline. I think doing good social
science involves recognising ideological influence, rather than pretending it
does not exist.